Choosing a Mortgage Term

By Jeff Brown
Before the deal is done, every mortgage shopper has to decide on the best “term,” or the number of years that my payments will last.

The choice between 15-year and 30-year fixed-rate mortgages is the most common. But sometimes you’ll see loans for 20, 25 or 35 years. Deals for 40 years appear from time to time, as well. In fact, the Obama Administration’s Making Homes Affordable program for homeowners facing foreclosure offers the option of extending loan terms to 40 years to bring down monthly payments.

The choice between short or long-term involves a simple tradeoff. A longer term reduces the monthly payment on a given loan amount, but it slows the build-up of equity in the home and increases the amount of interest paid if you have the mortgage for the full term.
The BankingMyWay.com Mortgage Loan Calculator shows how changing the loan term affects the results. To keep it simple, we’ll assume the same 5 percent loan rate regardless of the term, though shorter terms usually come with slightly lower rates.

With a 15-year term, you’d pay \$791 a month for every \$100,000 borrowed, and you’d pay \$42,343 in interest over 15 years.
Change the term to 30 years and the monthly payment falls to \$537, but total interest more than doubles to \$93,256.
The calculator doesn’t go to 40 years, since super-long loans have not been common as of recent, but one of these would charge \$484 a month and \$131,454 in total interest over four decades.

Now consider what happens to equity, which is the difference between what the home is worth at any given time and the amount still owed on the mortgage, or the “principal.”  Since we can’t predict future home values, we’ll look at how fast principal falls with different loan terms.
After 10 years, remaining principal would be \$41,905 on the 15-year loan, \$81,342 on the 30-year loan and \$89,824 on the 40-year loan.
At first glance, it seems you would be nearly \$40,000 wealthier if you’d chosen the 15-year deal over the 30-year one, since your remaining debt would be that much lower. But, of course, you’d have paid \$254 more per month on the 15-year deal, or nearly \$31,000 more over the 10 years.

Suppose that you invested that \$254 for 10 years at a 7 percent annual return. Using the Savings Taxes & Inflation calculator, you would find that you would end up with nearly \$43,700 in 10 years. The investment gains would more than offset the \$40,000 you could have “earned” by paying the debt down faster with a 15-year loan.

Choosing a loan term obviously depends on your personal circumstances and expectations.  For many borrowers, the size of the monthly payment is the most important factor. If the bigger payment on a 15-year loan is too much, the 30-year deal is unquestionably the better choice for you.

Another thing for the borrower to consider is how long he or she is likely to keep the loan. If you move or refinance in just a few years, the interest savings and principal reduction enjoyed with a 15-year loan may be less valuable to you than the smaller payment you’d face with the 30-year deal.

If you’re a savvy, disciplined investor, it could pay to get the loan with the longer term and invest the savings in monthly payments.
Keep in mind, though, that when you get a loan with a shorter term, the savings through reduced interest payments and faster debt reduction are guaranteed. An investment you choose as an alternative might be more risky.

Use the mortgage-shopping tool to find the best deals, and be sure to look at local lenders in addition to the big nationwide firms like Wachovia (Stock Quote: WFC) and JPMorgan Chase (Stock Quote: JPM).

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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